Sunday, January 6, 2013

Canada's Perfect Storm?

Canadian oil has become the world’s cheapest crude due to a combination of surging production, lower demand due to refinery maintenance and a chronic shortage of pipeline capacity that has created a glut in the oil-rich province of Alberta.

This week the cost of Western Canada Select, the regional benchmark for low quality, viscous heavy oil, has fallen to less than $45 a barrel – less than half the cost of other crude oil benchmarks.

Oil companies in Canada pumping heavy crude, such as Toronto-listed Imperial Oil and Suncor Energy, are selling their production for a bargain; less than half the near $110-a-barrel cost of Brent, the global benchmark, in the London-based ICE Futures market.

The country’s trade balance and currency are suffering as a result. Charles St-Arnaud, economist at Nomura, says Canadian oil producers are earning C$2.5bn less than they should every month.

“This implies a revenue loss of about C$30bn a year, or about 1.6 per cent” of gross domestic product for Canada, he says.The situation is likely to get worse in the first half of 2013 before it improves.

On Thursday, the price differential between WCS and West Texas Intermediate, the US benchmark, widened to $41 a barrel, the most since December 2007, according to Reuters data. WTI is already trading at a discount of $22.50 a barrel against Brent, creating a massive gap of $62.50 a barrel. Even counting the barrels of Iranian oil moving in the black market due to sanctions, no other crude is cheaper, traders said.

Brent crude on Friday traded at $109.04 a barrel, up 1.9 per cent on the week.

The plunge in the value of WSC relative to other benchmarks comes after Canadian oil production surged above 4m barrels per day for the first time in August, the latest data available, on the back of the oil sands boom, according to data from the US Department of Energy.

Oil sands are a concentration of a mix of sand, clay, water and viscous crude oil that producers extract, in some cases using conventional mining techniques. The crude is later separated from the sand.

Since 2000 until the middle of this year, oil producers in Alberta, the province where most of the oil sands mines are located, have added 1.4m b/d of new production to the market – equal to the total production of a midsized member of the Opec oil cartel, such as Libya. The boom is continuing, with Imperial Oil planning to add another 110,000 b/d in early 2013 with the opening of its Kearl crude oil sands mine.

With more crude from the oil sands flowing and pipeline capacity unchanged, Canada is likely to remain the bargain basement of the global energy industry.

Within the last two weeks, the oil market delivered some bad news for oil and gas companies operating in Western Canada. The bad news can be summarized by the headline of an article on the commodity page of the Financial Times: "Canada's oil becomes cheapest in world amid glut in Alberta."

The forces that have created this situation include surging oil production, lower demand due to refinery maintenance and a chronic shortage of pipeline capacity to move growing volumes beyond the regional Canadian market. The impact of these conditions caused the price for Western Canada Select, the regional benchmark for low quality, viscous heavy oil, to fall below $45 a barrel, less than half the cost of other crude oil benchmarks. This price disparity is estimated to be costing the Canadian oil and gas industry about C$2.5 billion per month, or an annualized income loss of C$30 billion, or about 1.6% of Canada's gross domestic product.

With the price of Canada's heavy oil this low, it is selling for less than half the $111 a barrel price (December 26, 2012) consumers are paying for Brent oil, the global oil benchmark. Furthermore, Canada's oil is now selling at about $41 a barrel below the United States' benchmark West Texas Intermediate crude oil, which in turn is trading nearly $23 a barrel below Brent.

The gap between WTI and Canada's oil price is the most since December 2007. Prospects are that the situation is likely to get worse in the first half of 2013 before it improves. These low levels for the benchmark crude oils of North America reflect surging production in the United States that has been unleashed by the oil shale revolution and the rise in Canada's oil sands output. Based on the latest data available from the Energy Information Administration (EIA), Canada's oil production has climbed above four million barrels a day (mmb/d) while U.S. production is the highest it has been since 1998. Until oil consumption ramps up, or Canada finds another export market or the U.S. government liberalizes its oil export restrictions, the glut in North American heavy oil will continue to grow.

Since 2000, with the growth in oil sands output, Alberta's total oil production has increased by about 1.4 mmb/d. Plans call for an additional 100,000 barrels per day of oil sands output coming on line early next year from Imperial Oil Company's (IMO-NYSE) new Kearl mine. Canada's production growth is about equal to the output of Libya, a mid-sized OPEC producer, showing the significance of the country's new output in the global oil market.

Until this production glut is resolved, Canada' crude oil will continue to sell at a steep discount to other benchmark crude oils, costing Canadian producers significant cash flow. That means there is a growing likelihood that as this wide price gap continues producers will be forced to reduce their expenditures compared to what they would spend otherwise. That could be bad news for the Canadian oil and oilfield service industry in the second half of 2013 if the pricing gap doesn't shrink.

Federal and provincial governments are reeling from the impact of the lack of pipelines and new markets for Alberta crude - an alarming dilemma that could cost Canada more than a trillion dollars in lost economic activity.

With no quick fixes in sight, both the federal Conservatives and the Alberta Tories led by Alison Redford are now readjusting revenue projections and deferring plans to balance their respective budgets.

Alberta's oilsands bitumen is selling at a $36-a-barrel discount because of a glut of oil in the United States and a lack of pipelines to get the Canadian product to the eastern and western coasts and down to the Gulf of Mexico.

The Canadian Energy Research Institute (CERI) has estimated that if three major pipeline expansion projects don't get built, the country will forgo as much as $1.3 trillion of gross domestic product and $276 billion in taxes over the next two decades.

"If we do not take heed of warnings and diversify our markets for energy by building infrastructure like pipelines, then our resources will be stranded and we will lose jobs and businesses in Canada," Oliver told the Saint John Board of Trade last month.

"We're losing $50 million every single day - $18 to $19 billion every year - because our resources are landlocked."

In a later interview with the Herald just before Christmas, Oliver said the numbers are likely even higher as the differential has increased since he gave the speech. CERI says the lost revenue could now be more in the range of $75 million a day.

Oliver said the situation "is screaming out for us to diversify, and we need pipelines to do that.

"This whole area is incredibly important to the economy of the country and it is so dynamic and changing - not only in Canada, but globally - that I expect it will be top of mind as an issue through (2013), and it will be a major focus, of course, for me," he said.

The federal government has pushed back its plan to eliminate the deficit by two years as a result of a recent projections of a $6-billion revenue shortfall.

"It doesn't take a rocket scientist to figure out that the reason they have deferred balancing their budget out two years from where they first talked about it is in large part due to commodity prices," Alberta Finance Minister Doug Horner said in an interview. "That differential is starting to hurt the national economy - not just Alberta."

Horner said the discount - the differential between the price for benchmark West Texas Intermediate (WTI) oil and Western Canada Select, which represents a blend of conventional heavy crudes and bitumen - is far more serious than he initially believed when the province released its second-quarter fiscal update in late November.

In a hastily called scrum outside his office a week before Christmas, a grim-faced Horner warned that cuts are coming in next year's budget to address a projected shortfall in revenue, which he didn't specify, but which sources have warned could hit $6 billion to $8 billion."I'm very, very concerned where those numbers are headed," he told reporters.

In recent months, the differential appears to be widening, rather than narrowing, and that spells even bigger trouble for Alberta in the future because provincial production is expected to ramp up to 4.5 million barrels per day- up from 2.2 million - and most of that increase is from the oilsands.

In mid-December, bitumen was selling for $47 a barrel - $40 below the WTI price and nearly $60 below the global Brent price. The differential has hovered around $32 to $36 a barrel in recent days.

CERI senior research director Dinara Millington said the large differential means Alberta is getting lower royalties and the federal and provincial governments are getting less in corporate taxes."Producers are losing money and hence they are paying less taxes and less royalties and overall GDP for the province and the country is lower," she said.

The situation is compounded by higher operating costs, which petroleum producers can deduct before they pay taxes and royalties, she added. "It's like a double whammy."

Horner said in an interview the province may not be able to meet all of the commitments to stable funding for services and programs it made in the last budget and he warned the public sector will have to temper its wage demands.

"There are certainly some dark clouds ... that are going to be impeding Alberta's economic situation for the next little while," he said. "We're going to do everything ... to control costs, and to hit our targets, and that's going to be meaning some tough choices for the ministers."

Last spring, Alberta's Progressive Conservatives won a hard-fought election on the promise of a balanced budget by 2013, but that hope seems to be hanging by a thread eight months later.

The premier said Albertans are used to volatility in the oil-patch, but this is different.

"This is no longer just the price of oil being high or low," Redford said in an interview.

"This is about how our access to markets is impacting our product in particular. So the work we've been doing on a Canadian energy strategy, the work we've been doing in Asia, the work we've been doing to talk about why producing our resources is in the national interest, is what we're seeing now playing out across the country," she said.

One point on which the federal and provincial ministers agree is there is no silver bullet to resolve the dilemma.Analysts have suggested that even if pipeline expansion now underway adds a million barrels a day of capacity, it won't eliminate the price discount.

Public opposition to a proposed Northern Gateway pipeline running from northern Alberta to Kitimat, B.C., has some analysts giving the line only a 50-50 chance of proceeding. But Horner said the work Redford has been doing in meetings with other premiers, United States energy executives and Chinese officials has laid the groundwork for the new markets Alberta needs for the future.

"Obviously, we're trying to work collaboratively with other jurisdictions to ensure there are no impediments that are put in the way of us achieving that market access," Horner said.

"We've also had some discussions with New Brunswick about moving product right out to the East Coast for export, which looks very promising."

The finance minister said market access for provincial crude is "a very, very big and critical issue for Alberta."It's also a big issue for the federal government, which takes the lion's share of tax revenue from the oilsands.

CERI estimate the oilsands will generate $44 billion in tax revenue across Canada over the next 25 years - and more than 70 per cent, or $332 billion, will go to the federal government.

Federal Minister of State (Finance) Ted Menzies said Ottawa will not be happy to see how much money it is losing, but the government won't be investing in any pipeline companies."The federal government isn't in the business of building pipelines," Menzies said. "It's the private sector that needs to be involved in that."

But he said it's no secret that, in the interim, pipeline companies are looking at reversing existing lines to move bitumen east.

"If we can actually move our bitumen to refineries in Central Canada or Eastern Canada, we lower that differential and it is good for all of Canada."

Horner said until the pipelines get built, Alberta producers could move their product by rail.

"We need to take a very serious look at every opportunity we have to expand our market access, because it is the critical component to a landlocked province that is an energy producer in a jurisdiction with rising production," he said.

But the problem isn't demand, it's infrastructure and the lack of pipelines to deliver all this oil safely to other destinations. And with Canadian pipeline companies getting hammered in the New York Times over the flaws in pipeline leak detection systems, garnering up public support for more pipelines will be that much more difficult (nonetheless, media articles are full of holes as pipelines are safer than people think).

As for the great Canadian oil glut, it couldn't have come at a worse time. Coupled with the great Canadian condo glut, there is a perfect storm brewing up here which will seriously impact our economy for a long time (start shorting the loonie!). It's déjà vu all over again for Alberta as they haven't learned anything from the last oil boom & bust episode.

Below, a video circulating on YouTube discussing the environmental devastation from tar sands production. The video was posted on Twitter by Anonymous and obviously doesn't paint a nice picture of tar sands oil extraction, calling it the "Dirty Truth" (not sure how accurate all these claims are as it has an Al Gore conspiratorial feel to it).

And Dinara Millington, the Canadian Energy Research Institute's Senior Research Director, explains why studies show that without new pipelines there is the potential for a $1.3 trillion dollar hit to the future Canadian and Albertan economies. Cannot embed it but you can watch this video here.

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I am an independent senior pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest. Please remember to support my efforts by clicking on the ads on the blog but more importantly by contributing via PayPal clicking on the buttons below. Anyone can contribute any amount at any time (all tips are greatly appreciated) but institutional investors are kindly requested to support this blog via an annual subscription of $500, $1000 or $5000 CAD (third option includes specialized consulting mandates). For all inquiries and comments, email me at LKolivakis@gmail.com.

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